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State Street Global Advisors' strategist and senior portfolio manager George Hoguet, who helps guide the firm's roughly $2 trillion in assets, is a former U.S. Treasury official who studied history in college. During our conversation last week, he paraphrased the German philosopher Hegel, saying that historians "can only understand the age after it has passed." He did, however, offer some clues about how long "the Great Recession" might last. (Quick answer: For a while.) Hoguet, an expert on emerging markets, also told us why they still looked more attractive than their developed counterparts. To find out exactly what he likes, read on.

Barron's:What can you tell us about the Great Recession?

Hoguet: In October, I attended a conference entitled "The Long-Term Effects of the Great Recession" at the Boston Federal Reserve, where a number of papers were presented by leading scholars, and Ben Bernanke spoke. The evaluation form asked whether we thought that 50 years from now scholars would be studying the Great Recession much as we continue to study the Great Depression. My answer was a resounding "yes." A very interesting paper by David Papell and Ruxandra Prodan of the University of Houston looked at the experiences of Japan, Sweden, Finland and Norway after severe banking and financial crises. It asked whether the potential growth rate of GDP had been permanently reduced as a result, because of people dropping out of the labor force, losing skills, and things like that. Based on their historical analysis the evidence suggests there is no permanent loss of output potential. On the other hand, the average slump lasted nine years. So by that yardstick, we are only halfway through.

"Given that the European Union is larger than the U.S. economy, it is impossible even for the U.S. to decouple from a significant recession in the EU." —George Hoguet
Brian Smith Boston for Barron's

Most postwar recessions resulted from Fed tightening designed to moderate inflation and/or oil shocks. For example, both contributed to the first Reagan recession. You typically get several quarters of above-trend growth as you snap back from the recession. That hasn't been the case here. We've actually seen below-trend growth. The reasons are partly because we had so many workers employed in housing, and there is an oversupply of housing, and then, of course, because of the debt deleveraging. This is a balance-sheet recession, which will take many years to work our way out of.

Balance-sheet recession is economist Richard Koo's term for Japan's long slide as asset values fell and balance sheets were under water. Is the West in that situation, too?

Yes, though the dynamics are a little different. If you look at aggregate indebtedness of all sorts, particularly in the U.S. and also the United Kingdom, and obviously in Spain and the peripheral countries, it has risen sharply over the past 20 years. The sectoral component obviously differs. In the U.S. and the U.K., consumer debt has risen very, very sharply. In the GIIPS [Greece, Ireland, Italy, Portugal and Spain], there has been more sovereign debt. Now, demand for funds is limited and obviously, the supply of funds is more restricted. There was a lot of consumption that probably should not have been financed, and now we just have to work off the inventory. It has compounded in the case of Western Europe with the need to recapitalize the banks and maintain a sustainable debt-to-GDP ratio.

How long will the Great Recession last?

The developed economies will see several more quarters of below-trend growth as the deleveraging continues. Just to put it in perspective, European banks are likely to deleverage by 1-to-1½ trillion euros ($1.29 trillion to $1.94 trillion) in the next 18 months. That means credit contraction. It is not yet certain that the crisis and Great Recession have permanently reduced GDP. Citibank estimates it will take the euro zone and the U.K. until 2016 to get back to the level of output they had in 2008's first quarter. That's an eight-year hiatus. Even prior to the crisis, estimates of potential GDP growth for many developed markets were falling, based on demographic factors. Of course, the more shocks that come along, like $200 oil from a conflict with Iran, or Bird Flu, will compound it. We in the developed world are still, after all, about 65% of the world economy.

There are large elements of uncertainty. We are facing a variety of intellectual crises. One is that the impact of our financial system on the real economy is constantly underestimated. Two is that the old central-bank belief that price stability would lead to macroeconomic stability is clearly not true. Three is in efficient-markets theory: Proponents of modern-portfolio theory didn't claim market efficiency implied perfect foresight, but that's the way it was taken. Such gross misvaluations shouldn't happen, but they did. We had the Internet and subprime busts all in a period of 10 years.

We also see fiscal consolidation in Europe, and the prospect of more sovereign downgrades and funding stresses in the euro zone. There are elections coming up in France, Russia, Taiwan and the U.S. -- all of which contribute to the equity risk premium being high, and lack of confidence in political structures. There's less confidence about the self-restorative power of the economy. If another shock hit the global economy, deflationary pressures could intensify.

What's that mean for developed markets?

The markets are concerned about lack of credibility and consistency in government policies. Last year, 2011, was the year of the policy mistake: Japan's terrible nuclear accident; the Arab spring that resulted from political repression; the debt downgrade in the U.S. and our inability to come to grips with our fiscal condition; and a series of European summits that were consistently behind the eight-ball.

The so-called equity-risk premium -- the amount over bonds that people have to be paid to hold stocks -- is close to a 40-year high. Many stocks are yielding well in excess of 2.4% to 3%, and well in excess of the 10-year Treasury.

Valuations by historical metrics are extremely attractive. At the start of this century, the 12-month forward P/E was more than 25 times for developed markets. Now we are down to 12 times. Non-financial corporate balance sheets are in good shape, and cash as a percentage of assets is high. Why are those companies hoarding cash? One, they are concerned about the potential for another liquidity shock. Two, there is uncertainty about government policy, about health care and other issues. That raises the risk premium. Now corporate cash is being used to buy back stock and increase dividends. But the prices in the market today imply a slower rate of economic growth than what we saw between 2000 and 2007.

Don't forget that from 1969 to 1979 U.S. stocks returned 3.5% per annum in nominal terms -- and in real terms fell 15%, given the high inflation of the 1970s. The Great Bull Market began in 1982, after the initiation of Reagan's supply-side policies and confidence in Volcker's inflation-righting resolve.

I'm not suggesting that I think there is scope for the markets to rally next year. I'm just trying to explain why valuations are where they are.

What do you recommend?

In our tactical asset allocation we are very, very modestly underweight equities. The forward P/E of the MSCI World Index is only 11 times, while earnings are expected to grow 11.2%, based in part on strength in China and the rise of domestic demand in East Asia.

In my judgment, for global equities to mount a sustained rally, the markets have to be convinced that there is a credible program for growth in the euro zone that deals with some of the structural issues, and also a more competitive exchange rate. The euro is going to fall. Given that the European Union is larger than the U.S. economy, it is impossible even for the U.S. to decouple from a significant recession in the EU. For the euro zone, we are forecasting zero growth or a contraction of 1%. Given that there's a credit contraction and the inter-bank markets continue to experience strains -- that is not confidence-inspiring. Many strategists actually come through this office suggesting there is better value potential in credit products.

What is your view of emerging markets, which lagged U.S. shares last year?

There were a couple of specific reasons. Some small markets like Egypt had political transitions. India had very high inflation. A number of countries were raising rates throughout much of the year. The currencies were hit as well. This is important: European banks are major lenders to emerging markets -- in their backyard, as in Eastern Europe, but also around the world. As some of those funding lines were cut, the emerging markets underperformed. It was the U.S. that outperformed, because it addressed its financial crisis issues more rapidly than Europe. Emerging markets are still very much part of the risk-on/risk-off trade in the world. People say they're half the world economy. Well, that's on a purchasing-power parity basis. On a nominal basis, they are only about 35%–not large enough to drive robust global economic activity on their own.

The cyclical environment for emerging equities is not the most propitious -- we have a rising dollar slowing growth expectations, policy uncertainty, uncertainty about commodity prices and concerns about China. If there's a mild recession in the euro zone, the emerging markets can withstand it. If there's a steep recession or a disruptive default, then they will be caught up in this. They have a beta of 1.2 to the MSCI World Index, so if the world goes down 1%, they will go down 1.2%. In crises, it can be higher. They are very sensitive to global economic activity and risk appetite.

But for the 10 years ended December 2010 they outperformed the developed world by about 10% per annum, and U.S. stocks did nothing. The secular case continues to be very strong. They will grow 4½ times as fast as developed markets next year. A number of factors argue in their favor. They have stronger balance sheets and greater policy flexibility. Their banks are in better shape. Domestic demand is rising. They have an important trading partner in China, which is now the world's second-largest economy, growing around 8% a year. For many countries, Chinese growth is as or more significant than U.S. growth.

So what do you suggest?

In our tactical asset-allocation accounts, we are overweight emerging equities. The Great Recession has enhanced the case for investing in emerging markets, by enhancing their growth differentials. China probably will exceed the U.S. as the largest economy in the world by 2025. The share of emerging-markets equities in global equity capitalization continues to rise. More emerging companies are globally dominant. ETFs mean the flows are more accessible to retail investors; therefore they are, arguably, more volatile.

The point is, for someone looking out three, five or 10 years, emerging markets should be a core holding in the portfolio. The starting point should be about 13% of the equity allocation. In the context of a 60% equities, 40% bonds portfolio, it would be about 7.8% of assets. That would be a neutral position, and one can take bets around that.

As the emerging opportunity set continues to grow, it is not just large-cap equities. It is also small-cap stocks, local-currency debt. Small-caps are promising because they're mostly companies focused on meeting domestic demand -- health care, consumer staples and the like, and the P/E of 7.8 is not demanding. A target weighting would be 1.5% of equities.

The larger point is that the developed/emerging distinction is artificial. Greece and Portugal not too long ago were emerging markets, and were upgraded to developed markets. Many emerging markets have sovereign credit that is superior to developed markets'. The way to control for risk aversion is the proportion one puts in these asset classes.

Some believe developed markets will outperform emerging markets in 2012, given compelling valuations.

I don't believe that's true. That's basically saying global equity markets are going to rally, and if global equity markets rally, emerging markets will outperform. Also, I think there will be a favorable surprise in that China won't have a so-called hard landing, which would put growth around 5%. And earnings prospects are more favorable in emerging markets than in developed markets. In the latter, margins are quite high and have the potential to fall.

Any markets you like?

Like a mutual fund, investors ought to run broadly diversified portfolios. Currency volatility will be a significant part of investing, but over time, emerging currencies are going to appreciate relative to developed currencies. Next year, I think it's reasonable to assume the euro will weaken some more. So we have been underweight the peripheral countries of Eastern Europe -- Hungary, Poland -- because they are impacted by what happens in the euro zone. Every investor should have a plan to invest in China, potentially through a regional ETF. China's capital-account liberalization is a significant story. The yuan appreciated again this year. It will be internationalized the way the yen was internationalized after World War II. The yield pickup in emerging debt is quite attractive, although debt is more focused on Latin America, and the equity is more focused on Asia.

Among countries, the most attractive include Brazil, Turkey and Indonesia. One of the big changes since the beginning of the year is that emerging markets, particularly the BRICs (Brazil, Russia, India and China), were in a tightening mode. Now we've seen countries either on hold or loosening. India is one of our biggest underweights, because of the inflation risk, and Russia is one of our largest overweights. Developments there may accelerate capital flight, but it sells at 4.5 times 12-month earnings and has very strong corporate cash flows. Turkey is growing very rapidly, and valuations are attractive. We also like South Korea, and don't anticipate a significant increase in tensions between the two Koreas.